Working of a Payment System

In today's era, fintech advancement has paved the way for digital marketing and e-commerce businesses. It has brought together and enhanced the trust between merchants and customers, where the customer buys goods and pays the merchants in just a few clicks. Contemporary entities in the payment processing cycle are radically changing the customer experience and making it possible for merchants to run their operations with a great deal of simplicity, unlike in the past when it was just about facilitating the transfer of funds.

In this lesson, we will describe the digital payment system and explain how a payment gateway has made the payment process easier in the modern world.

The payment process#

Online payment takes a few seconds. A customer simply has to enter their credit card details to pay online for the goods or services they want to buy. However, this is a very complex process that entails multiple steps and interacting entities—for example, cardholder verification, payment processing and validation, merchants registration, and so on.

The following figure illustrates the flow of a payment processing system:

The role of entities involved in the payment processing system is mentioned in the following table:

Note: Sometimes, another entity that sets between the issuer bank and cards network is involved, known as the issuer processor. The issuer processor facilitates the authorization, clearing, and settlement of a payment transaction on behalf of the issuing bank. However, many issuer banks have their own (in-house) issuer processors to have more control over the entire process, which often results in cost savings.

Let's take a closer look and explain the overall process of transferring funds that takes place behind the scenes.

The flow of payment processing takes place in the following steps:

1. The authorization phase

2. The settlement phase

The authorization phase#

Initially, we assume that the customer has an account in the issuer bank and the merchant has an account in the acquirer bank. The merchant also has a virtual account with Stripe, where all the transactions are stored in its databases. Now let’s discuss the steps involved in the authorization process:

1. The customers select the goods or services they want to purchase online, go to the checkout page, and enter their credit card information. Here, a transaction is created, including information about the customer, their credit card, the goods or services purchased, and so on.

2. The transaction information is provided to Stripe for further processing. Stripe stores the transaction details to facilitate funds transfer in the later phase.

3. Stripe routes the credit/debit card details and transaction information to the cards network.

4. The cards network performs the credit card’s authentication and passes the transaction information to the issuer bank to check the validity of the customer’s account information.

5. The issuer bank checks the status of the customer’s account and the availability of funds. Upon confirmation of their availability, it places a hold on the required funds.

6. The issuer bank responds with a successful authorization code to the cards network, which is passed to Stripe.

7. Stripe sends the authorization code to the acquiring bank.

8. The acquiring bank provides the approval to the merchant’s terminal, which in turn may provide the receipt to the customer.

9. Meanwhile, Stripe updates the transaction information in its database based on the authorization codes provided by the issuer bank via cards network.

The authorization phase is explained in the following set of illustrations:

Note: Every organization that processes, stores, or transfers credit card information should be PCI compliant. According to the PCI Security Standards Council, such organizations should use the secure file transfer protocol (STFP) to transmit sensitive data.

The settlement phase#

In the authorization phase, the credit or debit card information is validated. Moreover, the customer’s account is checked for the available amount, and the funds for the purchase are locked. In the settlement phase, the amount of all the successful transactions is transferred to the merchant’s account in the acquirer’s bank or to the virtual account in Stripe. This phase involves the following steps:

1. At the end of the day, Stripe collects all the transactions and corresponding authorization codes from the database and transfers them to the acquiring bank. The purpose is to withdraw the respective amount from the issuer’s bank.

2. The acquiring bank sends all data to the cards network to validate each transaction and its corresponding authorization codes.

3. The cards network routes all transaction information to the issuer bank for verification.

4. The issuer bank transfers the funds to the merchant account in Stripe after successful verification. The verification is performed against each authorization code provided in the authorization phase.

5. The issuer bank provides a bill to the customer or the cardholder for every successful transaction.

6. The merchant can later transfer the funds from the Stripe account to their bank account in the acquiring bank.

The activities mentioned above can take a few days to process for different reasons, such as ensuring fraud prevention, running bank processes, resolving disputes (if any), and so on. The flow of the settlement phase is depicted in the following illustration:

Note: In reality, the transfer of funds go through two separate entities:

• The payment gateway: A payment gateway requests and receives payment from the customer’s account.

• The payment processor: A payment processor facilitates the transfer of funds between a merchant and a customer's bank account. It is an essential part of the payment ecosystem because it is responsible for securely processing and verifying payments. 

Stripe can provide the functionality of both these systems.

In this lesson, we looked at the overall working of the payment system and the importance of the payment gateway (Stripe) within it. Let’s dive deep into Stripe, a well-known payment gateway, and its design API to understand more about its working in the next lesson.